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Zagg (ZAGG): Why Investors Should Zag Away From This Stock

by Sonya Colberg, Senior Editor - 8/23/2016 10:36:14 AM

We couldn't blame Zagg Inc. (ZAGG) if it's quietly suffering buyer's remorse.

But the cell phone accessory company will really be in trouble when investors understand the reason for the disappointment ... and that buyer's remorse rubs off on them.

The troubles can be traced back to shortly after February, when Zagg bought Mophie, maker of an iPhone battery case called Juice Pack Air. Mophie's pretty battery cases seemed to be flying off the shelves. So Zagg, looking to diversify, rushed in and bought out Mophie for $100 million.

It was supposed to be a fire sale.

Enter the PokemonGo craze. The augmented reality game launched July 6 and immediately became a phone battery hog.  Zagg's stock ran up 38% on hopes that Zagg could help address the need with its Mophie battery-extending case.

But now Zagg is positioned to run out of steam.

Investors may find other viewpoints here and the company website here. Meanwhile, TheStreetSweeper examines why Zagg's stock is now incredibly risky.

*1. Set Up For Failure

As it turned out, Mophie had been losing multi-millions. Amid growing competition, the case business has deteriorated, handing Mophie a 2015 loss of $29 million.

Zagg management justified the $100 million cash-and-debt acquisition of Mophie by touting sales and growth figures.

"Mophie’s 12-month sales are estimated to range from $210 million to $230 million, or sales growth of 3% to 13% compared to 2015 estimated sales of $203 million," said chief financial officer Bradley Holiday during the March 9 earnings call.

Then two months later, after everyone had forgotten about management's estimates, the pro forma numbers came out.

Sure enough, Mophie sales had grown only slightly to about $186 million ... The reality was $24 million to $44 million less than those fancy touted numbers.

(Chart 2 Source: Zagg SEC filing)

Now those exaggerated numbers have set Zagg up for failure....

*2. Touted Growth Despite Deteriorating Business

Since 2015 sales were puny compared to those touted by management, the Mophie segment will have to sell a ton of cases this year:

The Mophie segment must be gulping over those expectations ... since the business has been deteriorating over the last couple of years.

Revenue had fallen in both 2014 and 2015, compared to 2013. Operating losses had jumped significantly every year since 2013.

 

(Source: Zagg SEC filing)

After becoming a Zagg acquisition, Mophie sales in the first half of this year hit only about $50 million (here, here). Now if it wants to meet that $210 million to $230 million goal, the segment's got to cough up just about $170 million.

That means Mophie is expected to make more than 70% of the year's sales in just six months.

But Mophie's history dictates it will fall short...

*3. What Zagg Apparently Missed

Zagg should have seen the red flags raised by Mophie.

For example, Mophie apparently had to prepare for retailers to return many unsold products in 2015. From 2013 to 2015, the company tripled its allowance for returns.

 (Source: Zagg SEC filing)

At the same time sales return allowances rose by $22 million, Mophie's sales dropped by $29 million.

And Mophie became so anxious about sales that its expenses for paying distributors to advertise Mophie products have gone out the roof. Credit for cooperative advertising almost tripled to $9.5 million... as sales fell.

*4. “Price is what you pay. Value is what you get.”

Iconic investor Warren Buffett once said, "Price is what you pay. Value is what you get."

As a prime indication of Mophie's low value, Zagg ended up with the bulk of acquisition costs - a stunning $65.8 million - being spent on taking over Mophie's debt!

 

 (Source: Zagg SEC filing)

Mophie's poor shareholders only got a little over $300,000.

*5. "What's Your Margin?" Lower, Yet Exaggerated

If Shark Tank's Mark Cuban asked Zagg one of his favorite questions, "What's your margin?" he would be underwhelmed with the answer.

Zagg's gross margin in 2015 was about 38%. But under Mophie's influence, Zagg's margin dropped in the second quarter to 31%.

Indeed, it appears Mophie's gross margins may have been exaggerated.

CFO Mr. Holiday said during the August second quarter conference call in response to an analyst's questions about gross margins: "What we said in the past is that if you look at historical mophie gross margins they were in the high 20s, right around 30% and we felt we could get back to that level. We didn’t say we get back this year but that we felt overtime that we would be able to get them back at least up to historical levels..."

Yet here's how Mophie's gross margins work out, according to Zagg's SEC filings. Management's optimistic words sound quite far-fetched, suggesting that they expect Mophie margins to jump to levels unseen since 2013.

(Source: Zagg SEC filings)

Furthermore, if we assume the same selling, general and administrative costs ($65 million) on top of depreciation and amortization ($7.8 million) seen in 2015, Mophie's actual adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) remains negative.

That's a $-13.3 million EBITDA. So paying millions for a company that contributes negative millions is actually not such great bargain hunting, after all.

*6. Roth Analyst: Neutral On Zagg

In fact, Zagg's lower margins were mentioned by Roth Capital in a rather cautious note to investors on Aug. 3, the day after Zagg released its earnings report:

Lower Margins. Excluding a $2.2M write-up on mophie inventory, core
gross margin of 33.1% fell 430bps YOY due to an estimated 21% contribution
from mophie (below 1Q16’s ~25%) and keyboard promotions, offset by process
and mix improvements for legacy ZAGG.

Roth is the most recent firm to issue a note on Zagg, rating the stock "neutral" (Roth rates only 14% of stocks a "neutral," 74% are rated "buy") amid concerns surrounding the Mophie acquisition.

After the Aug. 2 report of core earnings of $0.11, beating consensus of $-0.03, Roth inched its Zagg 12-month price target to $6.50 from $6.

But Zagg was already fetching $6.36 at the time.

(Source: Yahoo)

Roth's 12-month target seems optimistic, even though the firm places Zagg's target much lower than any firm's previous price targets.

*7. Mophie Brand: Beaten Out

Meanwhile, Mophie rival Anker ranks as the best seller on Amazon.com. Customer reviews are very good for many of the brands but better for Anker plus the Anker battery case is almost a third cheaper than Mophie's case.

(Source: Amazon.com)

So the reasons behind that Mophie fire sale are beginning to rack up. And now additional issues are beginning to reveal themselves ....

*7. PokemonGo: Here Today, Gone Tomorrow

The Pokemon thrill does not look sustainable.

Zagg stock took flight as PokemonGo launched on July 6 but Pokemon accidents, criminal activities and a general decline in interest in the game are raising serious questions about the game's viability.

Even Zagg management spoke cautiously during the recent earnings call about the Pokemon effect.

"While we can’t predict the sustainability of Pokemon, the most immediate positive impact has been a reduction in inventory both at retail and company owned as retailers are seeing increases in sales of power related products and the need to replenish their inventory."

Pokemon has resulted in dangerous incidents worldwide as the game requires players to wander around streets with their eyes on their smart phones. The danger has escalated further because players have begun hopping into their cars to race after the elusive Pokemon creatures.

Distracted Pokemon fans have ended up in accidents, fallen from bluffs, been victims of an attempted robbery, crashed a car into a school building and even had a run-in with a parked cop car. Concerns over the craze hit new highs with a fatality in Guatemala where an 18-year-old player was reportedly ambushed and shot.

And now Pokemon Go has dropped in Google Trends searches.

Searches for Pokemon reached the highest point in July when the game was released in the United States, as shown below. But searches dropped the first week after launch:


(Source: Google Trends Search, accessed 8/22/16)

This suggests a trend that may be difficult to turn around. Game players simply don't cling to a lot of these games. They eventually yawn and run off in search of the next big thrill ... demolishing the stock along the way.

Zynga (ZNGA) probably best exemplifies the painful here-today-gone-tomorrow gyrations of the faddish games. In 2009, Zynga's Farmville hit digital paydirt, racking up 83 million monthly users as players "grew" crops and invited their Facebook friends to join in on paying real money to attain goods and levels. But the paydirt turned to drought as the company unsuccessfully scrambled to extend the franchise and players deemed the games nothing new. Just flat-out boring.

From March 2012 to November 2012, players left in droves and Zynga's stock plummeted by more than 80%. Today, the one-time $14-plus stock trades for little more than $2 per share.

(Source: Yahoo Finance)

Pokemon's mounting issues and decline in searches indicate this game may be more fade than fad. And interest in those battery cases will drain as Pokemon fades. In our view, Pokemon's attempts to regenerate excitement may initially work (a related product is designed to alert players to the characters' location without using the app) but will quickly die off as finicky players look for something new and unique.

*8. iPhone7: Not As Hot As 6?

Though Zagg sales are impacted by the introduction of new phones, the iPhone 7 is generally not expected to be anywhere near as successful as iPhone 6, history's most successful iPhone launch.

In early sneak peeks, the iPhone 7 looks pretty similar to the iPhone 6. So Apple is expected to have a tough time getting people to shelve their not-very-old phone and plunk down about $650 sometime around  September for a new phone that will apparently offer few improvements to the iPhone 6.

Forbes wrote that the iPhone market is saturated in the west. At least one analyst is predicting a 6% drop in iPhone sales this year.

Forbes wrote: "Sales of the iPhone cannot continue to rise indefinitely. At some point in the future, there will be a year-on-year drop in sales. And once the sales figures start to slide, even by a million or so units, expect a rush of negative coverage, falling share prices, and a general outpouring of ‘the sky is falling in on Apple.’"

Interestingly, one iPhone 7 rumor is that it may not need to be charged. So even if the new iPhone is more successful than many people expect, Zagg is darned if it is because that never-charge-it characteristic wouldn't help the battery case demand. And Zagg is darned if it isn't. If the iPhone 7 isn't particularly successful, that won't help the demand for Zagg's other phone accessories, either.

*Conclusion

Zagg piqued investors' interest when the company announced the planned acquisition and Mophie's anticipated numbers in February. But many people had likely moved on and lost interest by the time the real numbers came out in May. 

So the actual figures indicate Mophie was overblown even as it was suffering a business decline. Now Zagg has saddled the segment with absurd sales expectations. The Pokemon-induced stock rally virtually extended the gap between sales reality and expectations.

The sales had no choice but to disappoint. Weighty forces are conspiring to dampen them even more in the future ... forces like Pokemon's drop, iPhone saturation, Zagg/Mophie's awful margins, depressed market position and that wild dependence on Mophie's contribution to sales.

This confounding jumble of hype, messed up numbers and stock that's way ahead of itself will soon come together. Zagg shares will rapidly get hammered back from these insane levels to about $4.85 per share.

* Important Disclosure: The owners of TheStreetSweeper hold a short position in ZAGG and stand to profit on any future declines in the stock price.

  • Editor's Note: As a matter of policy, TheStreetSweeper prohibits members of its editorial team from taking financial positions in the companies that they cover. To contact Sonya Colberg, the author of this story, please send an email to scolberg@thestreetsweeper.org.
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